It may seem like mortgage rates are currently trending to infinity and beyond, and while rates have continued to creep up…and up…and up since the beginning of 2018, things aren’t as bad as they may seem. We can safely say however, that the run of historic low interest rates that have prevailed over the past few years is coming to an end. Analysts are generally in agreement that we are now entering a rising rate environment, something that has many worried about the futures of the mortgage and real estate industries.
Although there is some cause for concern, both Fannie Mae, Freddie Mac, and the new Fed Chair Jerome Powell have, as recently as yesterday, provided some reassurance on the current economic outlook. This helps put things into perspective and reminds us that although rates are going up, the economy continues to grow stronger and rising rates are a sign of this strengthening economy.
In their February Outlook, Freddie Mac analyzed and interpreted historical data to determine what happened in the past under similar circumstances in order to get a better idea of what various players in the real estate industry can expect in our current rate environment. What they found was that in the period of time between 1990 and the present, there have been 6 instances in which a rising rate environment has prevailed.* In each of the 6 periods analyzed, Freddie economists found that there were almost always reductions in:
- Mortgage originations – on average mortgage originations decreased by about 40% during these periods
- Homes sales—on average home sales decreased by about 5% during these periods
- Housing starts—on average housing starts decreased by about 11% during these periods
Typically the above accompanied an average increase in rates of about 1.46%. Further, Freddie was able to determine that two key industry players are/were hardest hit by rising rates: borrowers and lenders.
Borrowers: Borrowers are most directly affected by rising interest rates and are most sensitive to changes in rates. The reason being that when interest rates increase, monthly mortgage payments will increase as well. The higher monthly mortgage payments go, the more likely it is that first time homebuyers will be priced out of the market because they are unable to comfortably afford the proposed mortgage payment, or the DTI gets too high so they are unable to even qualify for a mortgage. This may cause potential first time homebuyers to turn to renting, either because they are unwilling or unable to make higher mortgage payments associated with increasing rates. The situation is even worse for existing homeowners who are looking to sell or refinance. For those who own but are looking to sell, the source of the down payment on their next purchase typically comes from their existing home. As interest rates rise, it often means the cost for financing increases and borrowers would have to give up their current below market financing for financing that is less advantageous. As a result, many existing homeowners will delay the sale of their existing home and purchase of a new home until the rate environment is more favorable or comparable to their existing financing.
For those who are looking to refinance, the situation is even worse. Typically borrowers are motivated to refinance by the desire to obtain better loan terms and a lower monthly mortgage payment. If rates are rising borrowers are likely to find that loan terms available today are less advantageous than their existing terms and will choose not to refinance as a result. Lenders will see this in a substantial decrease in their refinance volume which brings me to…
Lenders: Mortgage lenders depend on origination volume. As mortgage rates rise, demand for mortgages decreases causing a subsequent decrease in mortgage origination volume. The most dramatic decrease occurs in refinance volume but there is a noticeable decrease in purchase volume as well. As mentioned previously, the Freddie study determined that in increasing rate environments, origination volume generally decreases by around 40%. Earlier this month, Fannie Mae’s department of Economic and Strategic Research released their February Economic Developments in which they noted that, “The higher rate environment is intensifying industry competition and reducing profit margins. This competition may temporarily compress spreads resulting in industry downsizing that reduces capacity and ultimately results in wider spreads that restore profit margins for survivors.” In other words, decreasing mortgage origination volume will cause increased competition in the lending marketplace forcing some lenders to close shop however, what business is left in the market will assist lenders who do survive in preserving their profit margins.
While borrowers and lenders are the hardest hit by rising interest rates, realtors and builders experience some of the affects as well. Realtors and builders typically see delayed effects of increased rates in the form of lower sales volumes for realtors and less demand for new construction for builders. Although the results of increasing rates are largely negative, Fannie Mae’s February report did note that the impact of increasing rates largely depends on how fast rates increase. If rates increase proportionally with household income, the impact of rising rates may be negligible. Freddie took this a step further and used historical data to project what would happen to mortgage rates, originations, home sales, and housing starts if rates increased following three possible scenarios, as outlined below:
Scenario 1: Status quo continues, rates remain between 3.5%-4.5%
Scenario 2: Based on average experience from market moves during the 6 episodes of rising interest rates between 1990 and present
Scenario 3: Reflects most extreme experience/movements in housing and mortgage during 6 episodes
As we can see from the table above taken from Freddie’s February outlook, if things continue as is, mortgage and housing markets will continue along with small increases in originations, sales, and starts, and a slight decrease in rates. Under the second scenario, Freddie Mac economists posit that the average rate on a conventional 30 year fixed mortgage would rise above 5.25% before declining. Further, the Freddie report notes that with the weekly average rate at 4.4% as of February 22, 2018, we are already more than one third of the way there. For this scenario to occur however, inflation would have to increase significantly more than expected.
For the third and most drastic scenario to occur, inflation and expectations regarding future inflation would have to increase with mortgage rates remaining elevated for an extended period of time. This scenario closely resembles what happened to mortgage rates between 1977 and 1981. During this time period mortgage rates more than doubled from an average of 8% in 1977 to an average 18% in 1981. This shouldn’t cause alarm however because it is uncertain as to when and by how much mortgage rates will move. Further, we are more likely to experience a gradual increase over time that allows for markets to acclimate to this new higher rate environment so that any further increases aren’t a shock to the system.
For example, markets are already prepared for a March rate hike. As the Fannie Mae release notes, current market rates already account for the expectation that the Fed will raise the Federal Reserve rate in March. Additionally most analysts believe there will be two or possible three more rate hikes throughout the year, something the market is fully prepared for and which should not come as a surprise if and when they do occur. In this way the market may be preparing and protecting itself so that when these rate hikes do come it is not a shock to investors and lenders alike. It is also important to note that these Fed induced rate hikes coupled with Fed policy will be the biggest driver of rate movement in the coming months.
With the Fed in the chair driving rate movement, we can rest somewhat assured we are in good hands. Yesterday morning for instance, the new Fed Chairman Jerome Powell attempted to quell concerns about the higher rate environment and recent market volatility with his first testimony before Congress. Powell reminded us that the economy continues to grow and strengthen, and indicated that he will continue pursuing measured growth toward inflation and employment goals.
When asked about the Fed’s quantitative easing policy and whether the Fed would continue to purchase mortgage backed securities, Powell indicated that the tool of buying mortgage backed securities was an extreme measure reserved only for the direst of situations, and confirmed that he is not expecting to continue buying mortgage backed securities unless we face extreme economic conditions. Instead he will look to allow existing mortgage backed securities to roll off the balance sheet while the Fed pursues more traditional instruments of monetary policy. Powell also indicated in his prepared remarks that he is comfortable with how rates are trending and believes the current approach is working well, stating that, “In the FOMC’s view, further gradual increases in the federal funds rate will best promote attainment of both of our objectives. As always, the path of monetary policy will depend on the economic outlook as informed by incoming data.”
For now we have to trust in Powell and the FOMC while still maintaining a watchful eye on economic news, data, and trends to drive mortgage rates. I think it is safe to say however that higher rates are here to stay and while that may not be what our industry players like to hear, it is good to keep in mind that things could be worse. As discussed previously, those originating in the early 1980’s likely remember the days of double digit mortgage rates and while we have been spoiled since 2008 with artificially low mortgage rates, we must remember that increasing rates are a sign of not only a strengthening economy, but one that is normalizing.
*Freddie Mac defines a rising rate environment as, “A period in which the monthly average of the Primary Mortgage Market Survey (PMMS) rate for 30-year fixed mortgages increased by more than 1 percentage point from trough to peak”—Outlook, February 2018